On Dec. 8, 2021, the Delaware Supreme Court in AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, No. 71, 2021 (Del. Dec. 8, 2021) affirmed the holding of the Court of Chancery that seller breached the ordinary course covenant in the parties’ sale agreement by making operational changes in response to COVID-19 inconsistent with its past practice, relieving buyer of its obligation to close. We previously wrote about the post-trial decision in that case in What’s Past Practice Is Prologue: A Recap of Recent Developments in COVID-19-Related Delaware M&A Litigation. The Delaware Supreme Court’s opinion affirming Vice Chancellor Laster’s decision provides important guidance for practitioners regarding how Delaware courts will interpret and apply ordinary course covenants.

In AB Stable, in September 2019, buyer agreed to purchase from seller entities controlling 15 luxury hotels. As relevant to the court’s decision, the transaction had not closed by March 2020, and seller made “drastic” operational changes to the hotels in response to the COVID-19 pandemic, including closing two of the hotels, laying off employees to reduce staffing to “skeleton” levels and shutting down amenities. Seller later asked buyer for permission for these changes — which it claimed was not required and could not be unreasonably withheld — but buyer responded that it was not prepared to consent without additional information regarding the changes, which seller did not provide. On April 17, 2020, buyer sent seller a formal notice of default based on its failure to operate the hotel entities in the ordinary course of business and other inaccurate representations, including issues regarding title to the hotels (discussed in more detail in our article regarding the trial court’s opinion). On April 27, 2020, seller brought an action in the Court of Chancery against seller, seeking specific performance. After an expedited trial, the Court of Chancery found in its November 2020 decision that seller had breached the ordinary course covenant and a condition related to title insurance, denied seller specific performance, and awarded buyer the return of its deposit, its transaction expenses and legal fees, and interest. Seller appealed.

The Delaware Supreme Court affirmed the Court of Chancery’s finding that seller breached the ordinary course covenant, declining to reach title-related issues. The court held that ordinary course covenants “prevent[] sellers from taking any actions that materially change the nature or quality of the business that is being purchased, whether or not those changes were related to misconduct.” It rejected seller’s argument that “it was justified in taking reasonable, industry-consistent steps to preserve the business in response to the COVID-19 pandemic.” The court explained that “the parties did not choose the actions of industry participants as the yardstick to measure the Seller’s actions,” but whether the actions were “consistent with past practice in all material respects,” which “means that its compliance is measured by its operational history, and not that of the industry in which it operates.” Additionally, the court emphasized that “the covenant is absolute” and “does not have a reasonableness qualifier.”

The court also rejected seller’s argument that the trial court’s interpretation of the ordinary course covenant was inconsistent with the MAE provision that shifted pandemic risk to the buyer. It noted that the parties did not restrict breaches of the ordinary course covenant to events that constitute an MAE, that the phrase “in all material respects” in the ordinary course covenant applied a different and less stringent materiality standard than the material adverse effect analysis, and that the ordinary course covenant is meant to protect buyer from changes in the business during the pendency of the transaction, whereas an MAE clause allocates risks resulting from changes in the business’s valuation. And the court emphasized that the ordinary course covenant permitted seller to make changes with buyer’s consent, which could not have been unreasonably denied, but that the seller here declined to make a meaningful effort to obtain that consent. As the court concluded, “Seller was not required to run its hotels into the ground to comply with the Sale Agreement, but the Seller had a contractual obligation to secure the Buyer’s consent — not to be unreasonably withheld — before making drastic changes to its hotel operations. Having failed to do so, it breached the Sale Agreement, which excused the Buyer’s obligation to close.”

The Delaware Supreme Court’s opinion provides important guidance to practitioners concerning the interpretation and application of ordinary course covenants, including:

  • Delaware courts have found that the phrase “consistent with past practice” refers to the operational history of the business being sold, not the current practices of other companies in the industry. Such a clause without any qualifier for reasonableness will likely require that any changes to business operations unprecedented in the business’s history will require permission from the buyer.
  • Sellers should generally ask for permission not forgiveness if seeking to make changes to business operations, even in the face of extraordinary events. And even if a buyer is initially reluctant to consent to such changes, sellers should make and document a good faith effort to explain to buyer the necessity of the operational changes.
  • Delaware courts have determined that ordinary course covenants and MAE clauses serve different purposes, and will not attempt to reconcile ordinary course covenants with any risk allocation in the MAE clause. The ability of a seller to make operational changes to a business in light of a potential MAE without permission from the buyer will likely be determined by the language of the ordinary course covenant without reference to MAE provisions.